Buoyant economy, buoyant bond issuance

With economies, especially New Zealand's starting to pick up, Harbour Asset Management director Mark Brown looks at the outlook for fixed interest markets.

Wednesday, March 12th 2014, 3:36PM

by Harbour Asset Management

Key Points

Against a backdrop of emerging market unease and patchy economic data globally, New Zealand’s buoyant economy was underlined by even stronger news and data releases.
Long-term interest rates fell marginally, as global influences were the dominant influence.
We retain the view that we are on a path towards stronger global and domestic economies, where there is the possibility of inflation rising above the very well contained levels experienced since the GFC.
While market pricing is anticipating higher yields globally, we believe the risk is greater that yields rise further, rather than less than, yield curves imply.
In March we will see the Reserve Bank’s interpretation of the economic outlook and the projected OCR path that aims to deliver 2% inflation. Governor Wheeler can be expected to take exceptional care to craft a message that gives rate guidance, retains flexibility and aims to reaffirm the Bank’s inflation managing credibility.
It was a busy month for new issuance of corporate debt, with a total of $2,545m sold by 24 different issuers. We think this shows the NZ capital market to be in excellent shape and certainly stronger than was frequently suggested through 2013, when corporate bond issuance levels were lower.
We think it is unlikely that the wave of new corporate bond issuance will force credit spreads significantly wider, but we do expect the sense of unsatiated demand to diminish. A mild re-pricing of credit to wider spreads would not surprise us.
While emerging markets are grabbing the headlines, equity and credit markets are showing few signs of stress yet. An increase in risk aversion is a real possibility.

Domestic economic data just keeps getting stronger
Late in February another round of strong economic data were released. The ANZ Business Outlook reached the highest level since 1994, Fonterra announced a further increase in their projected payout for 2013/14 to a new record level and monthly net migration numbers continued their strong trend, underpinning demand for housing. In the ANZ survey, expected profitability also rose to the highest level since 1994, and is most probably behind a rise in investment and employment intentions to levels also not seen for 20 years.

Chart 1. Consumer and Business Confidence

An additional and perhaps overlooked aspect of the better data is the rise in our Terms of Trade to a level not seen since the 1970s. BNZ economists suggest we may be experiencing the best Terms of Trade since any sort of records are available, in 1861. The income and ‘feelgood’ impact of this should not be underestimated.

The stronger activity signals are accompanied by higher inflation signals, with pricing intentions and inflation expectations rising.

The data are consistent with a broad range of evidence that validates the ‘Rock Star’ label New Zealand has picked up lately, despite our persistent structural issues. However the market reaction to the strong data has become almost blasé, as there is a common view that the return to a neutral Official Cash Rate (around 4.0 – 4.5%), which is priced into market interest rates, is all that we will see from the Reserve Bank. In isolation, with growth forecast to rise towards 4% and inflation signals creeping higher, one might contemplate a prospect of monetary conditions moving through a neutral level to a tight level. This idea is reinforced by the Reserve Bank’s ‘alternative scenario’ in the December MPS, which argues that if the Terms of Trade stayed at current very elevated levels (rather than easing back as projected), tighter monetary conditions would be warranted.

The ongoing patchy path to global economic recovery is one reason to be a little more sanguine about New Zealand’s prospects. While there are signs the global economy is getting on better footing, notably in Europe, there are other, less upbeat signals. Chinese data are still slightly disappointing. The cold winter has affected activity in the US, and most Australian data is still subdued. However, for every weak sign, there are offsetting positive ones, making the overall picture one of gradual but erratic improvement. The IMF forecasts GDP growth in the Advanced Economies rising from 1.3% in 2013 to 2.2% in 2014. New Zealand looks streets ahead at 2.7% and 3.9% respectively, using BNZ forecasts.

Chart 2. GDP Growth Forecasts: New Zealand compared to other Advanced Economies

Source: BNZ, IMF.

The Reserve Bank’s March Monetary Policy Statement will be a defining moment
In January, Graeme Wheeler delivered a speech the day following the OCR review, explaining why OCR hikes will be required to ensure a sustainable economic recovery. The market is pricing a 25 basis point hike in March, and further increases lifting the OCR to 3.75% in 12 months. At present, this looks a plausible scenario. However, ongoing decisions will be made through the course of the year, based on developments in economic data and other influences. With economic momentum so strong at present, and with inflation expectations starting to increase, there is a chance the Reserve Bank accelerates the tightening path that is projected at present.

Communication will also be crucial. Governor Wheeler can be expected to take exceptional care to craft a message that gives rate guidance, retains flexibility and aims to reaffirm the Bank’s inflation managing credibility.

The influence of offshore markets
Despite all the strong data in February, market interest rates actually fell slightly as we followed global rate movements. Patchy data was a key influence, as were geopolitical concerns across a range of emerging economies. The progressive escalation of events in Ukraine, the North Korean missile launches, plus uncertainty in China about growth and the state of local government finances all highlight risks that might destabilise the path to a fuller recovery from the GFC.

The rise in the S&P500 to record levels suggests investors are far from unnerved about these developments to date. However we cannot discount a further deterioration that might prompt a change in risk appetite.

Corporate bond issuance surges
While issuance of corporate bonds is typically strong in the first quarter, 2014 has seen a particularly strong start. Through much of 2013 we frequently heard comments regarding the dearth of issuance in the corporate bond market. Issuance was quiet, for several reasons:-

The maturity profile was low, partly as the average term of bonds issued has been lengthening over recent years, meaning refinancing needs appear less quickly.
As a follow up to the GFC, corporate balance sheets and funding positions had been managed quite conservatively, so the requirement for funding was lessened.
For retail investors, issuance has possibly also been reduced as ‘wholesale-only’ deals have become a little more frequent.

In February new issuance totalled $2,545m, with a total of 10 deals marketed to domestic investors. Of these, $1,100m over 5 deals were sold under an Investment Statement and available to retail investors.

Table 1: NZD Non-government debt issuance February
Issuer	Amount	Type	Tenor
ANZ Bank	$400 mill	Domestic, retail	5 years
Christchurch City Council	$45 mill	FRN	6 years
Contact Energy	$200 mill	Domestic, retail	5 years
Fonterra	$250 mill	Domestic, non-retail	6 & 8 years
LGFA	$175 mill	Domestic, retail	1,3,5,7 years
Sky TV	$100 mill	Domestic, retail	7 years
Westpac Bank	$325 mill	Domestic, retail	4.5 years
World Bank, Kommunalbanken, Asian Development Bank	$850 mill	Kauri	5-10 years
Eurokiwi (14 issues)	$200 mill	Domestic, medium term notes	2-10 years
TOTAL	$2,545 mill

All of the issuers have existing NZD securities in the market, so no new names were launched. The term of the bonds ranged predominantly from 5 – 7 years, continuing a trend towards longer maturities that has existed over the last few years.

The motivation behind longer-dated issuance is two-fold. Firstly, issuers prefer to lock in long-term funding and banks are typically less willing to extend funding beyond 5 years, historically preferring 2-3 year timeframes.

Secondly, longer maturities offer investors higher coupons, due to the positive shape of the yield curve and the extra credit spread available for committing for a longer period. These higher coupons find favour with retail investors who look to achieve a higher running yield than bank deposit rates. Institutional investors have also become more willing to buy longer maturity corporate bonds. We believe this displays a greater depth to the NZ capital market.

Seasonal factors are likely to be one cause of the increased issuance, as corporate treasurers enter the New Year with funding markets in good heart, giving them the opportunity to lock in funding that would need to be arranged at some stage through the year. Pricing for hedging deals into desired currency and term e.g. floating US Dollars, has also been advantageous.

Looking ahead, we expect issuance to remain reasonably strong, especially as retail investors are likely to see higher coupons on deals as time progresses. Institutional investors also will have ongoing cashflow to invest, although the recent flow of deals may satiate current demand, meaning new deals need to be priced more generously to find strong support.

We have a fairly neutral view on credit at present. While the stronger economy creates a supportive credit environment, the margins available from corporate bonds have narrowed considerably over the last 18 months, making valuation less compelling.

Chart 3. Corporate bond spreads to NZ Government Stock

Source: NZFMA, Harbour Asset Management

Mark Brown,
Director,
Harbour Asset Management

IMPORTANT NOTICE AND DISCLAIMER
The New Zealand Fixed Income Commentary is given in good faith and has been prepared from published information and other sources believed to be reliable, accurate and complete at the time of preparation but its accuracy and completeness is not guaranteed. Information and any analysis, opinions or views contained herein reflect a judgement at the date of preparation and are subject to change without notice. The information and any analysis, opinions or views made or referred to is for general information purposes only. To the extent that any such contents constitute advice, they do not take into account any person’s particular financial situation or goals, and accordingly, do not constitute personalised financial advice under the Financial Advisers Act 2008, nor do they constitute advice of a legal, tax, accounting or other nature to any person.. The bond market is volatile. The price, value and income derived from investments may fluctuate in that values can go down as well as up and investors may get back less than originally invested. Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance. Bonds and bond funds carry interest rate risk (as interest rates rise, bond prices usually fall, and vice versa), inflation risk and issuer credit and default risks. Where an investment is denominated in a foreign currency, changes in rates of exchange may have an adverse effect on the value, price or income of the investment. Reference to taxation or the impact of taxation does not constitute tax advice. The rules on and bases of taxation can change. The value of any tax reliefs will depend on your circumstances. You should consult your tax adviser in order to understand the impact of investment decisions on your tax position. To the maximum extent permitted by law, no liability or responsibility is accepted for any loss or damage, direct or consequential, arising from or in connection with this document or its contents. Actual performance of investments managed by Harbour Asset Management Limited will be affected by management charges. No person guarantees the performance of funds managed by Harbour Asset Management Limited.

Important disclaimer information

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